Global Economics

Zetsche's Chrysler Dilemma

It's a bittersweet first anniversary for Dieter Zetsche, who became chief executive officer of DaimlerChrysler (DCX) one year ago. Mercedes was bleeding red ink at the time. Today it is on the mend, with sales up 11% this year through August. First half profit was $162 million, compared with a loss of $1.2 billion a year ago. But Daimler's U.S. unit, Chrysler, is skidding toward a $1.26 billion loss in 2006—and hopes are fading that it will ever power big profits in the future. "It's up to DaimlerChrysler to prove that it can rebuild Chrysler or find a way to relieve itself of the burden," says Merrill Lynch auto analyst Stephen Reitman. "The clock is ticking."

The huge Chrysler loss is a nasty blow for Zetsche. After two years of steady gains, Chrysler was widely considered the healthiest of Detroit's automakers. But its sudden and dramatic reversal demolishes once and for all the logic of the eight-year-old merger. Former CEO Juergen Schrempp, who stepped down Jan. 1, promised a marriage made in heaven and huge synergies. Instead, Daimler poured billions of dollars into Chrysler, draining management and resources, and repeatedly dragging down the German luxury automaker. The 2006 loss is the third setback in six years.

In a conference call with analysts on Sept. 19, even Zetsche, who led the turnaround at Chrysler, admitted the U.S. unit offers no serious advantages of scale to the Mercedes Car Group. The average selling price for a Mercedes is $52,800. Chrysler's cars sell on average for $22,673. Zetsche insisted a spinoff isn't under consideration and said management's first priority is to fix the problems at Chrysler by trimming production and redoubling efforts to boost its competitiveness.

NO COMPETITIVE BOOST. But it's increasingly clear that Mercedes, which makes up roughly 33% of Daimler's $200 billion in revenues, doesn't get any competitive boost from Chrysler, and Daimler would be a stronger and more profitable group without the U.S. unit. Rival BMW has already proven that a premium car company can produce strong growth and top profits without the volume of a mass market brand. What's more, radical restructuring and improved models have failed to deliver a solid recovery at Chrysler. That's because the negative dynamics of the U.S. auto market and Chrysler's legacy labor and health care costs make it nearly impossible to earn a profit, let alone the 5% operating margins that Daimler was counting on when it wooed Chrysler.

With Mercedes' earnings on the mend, there's no immediate crisis. Analysts are now forecasting breakeven for Chrysler in 2007 and a modest $1.2 billion operating profit in 2008. But subtract pension costs from that $1.2 billion and Chrysler will still be struggling with a net loss ten years after the merger, analysts say—and far from earning its cost of capital. Given the brutal conditions of the U.S. auto market today, it is hard for Daimler to reap adequate value from the link-up with Chrysler.

Zetsche's options are limited as long as Chrysler is ailing. But analysts believe that once the losses at Chrysler are stanched, Daimler's supervisory board will consider all its options for undoing the merger down the road. Other mass-market automakers such as Peugeot or even Ford (F) might be able to wrest greater benefits from a hook-up than Mercedes, says Garel Rhys, professor of automotive economics at Cardiff University in Wales. Responding to a question about the logic of holding onto Chrysler, Zetsche admitted in the Sept. 19 conference that management could not rule out changes in the group's long-term structure.

"THEY NEED TO GET OUT." The longer it takes to get Chrysler earning decent margins, the louder the chorus to liberate Mercedes from Chrysler is likely to grow. Reitman forecasts a 2006 group net profit of $3 billion for DaimlerChrysler, down 17% over last year. "I think they need to get out—unless there is a massive turnaround in the U.S. auto industry's fortunes," says J.P. Morgan analyst Philippe Houchois.

At DaimlerChrysler's current $50 billion market capitalization, Merrill Lynch puts Chrysler's value at "below zero" in a Sept. 20 report. Zetsche says that a raft of 10 new models in 2007 will help power a recovery at Chrysler. But Chrysler's dependence on trucks, sport-utility vehicles and minivans—all of which are in freefall—for 71% of its sales leave many wondering how much new products can help. "The perception and confidence in sustainable change at Chrysler is presenting an obstacle for us," admitted Zetsche.

While Japanese automakers sell their cars at a healthy profit in the U.S., Chrysler, GM, and Ford are forced to offer discounts so large that they are barely making any money for their efforts. "The number of hours to make a car at Chrysler, Ford, and GM is the same as at the Japanese implants," says Rhys. "The difference is in profit per employee. The Americans have to basically bribe consumers to take a car they otherwise wouldn't buy."

Mercedes is now the bright spot for Zetsche, who forecasts the premium German carmaker will deliver on the company's 7% operating margin target in 2007—or even slightly exceed it, powered by a raft of new models, including the all-important new C Class which will hit showrooms early next year. He also assured investors that the Mercedes Car Group could even exceed the 7% margin level in coming years. "The only direction it will go after 2007 is up," says Zetsche. Thanks to that newfound strength of Mercedes, Zetsche may just get the time he needs to resolve his Chrysler dilemma.